Don’t allow taxes to unduly influence strategy

Q: About a year ago, the company that I worked with for more than 30 years closed its doors and went out of business. At the time, I received severance pay, which was a year-and-a-half of my salary. I have been living off that money and it will be up in a few months. I am in my late 60s and I have decided to retire. I will be collecting Social Security, but that will not cover my needs. My question to you is, from a strategy standpoint, where should I get the additional income I need? I have three buckets of money: a traditional IRA, Roth IRA and personal investment account at Vanguard. Between the three accounts, I have nearly $1 million and I will need about $2,000 a month in addition to Social Security. What accounts should I access first? I have been told that I should first use my personal account before I touch my IRAs. Do you agree?

A: No, I do not necessarily agree with that strategy. That strategy is based upon the theory that, since your traditional IRA is subject to tax, it would make sense to defer paying the tax for as long as possible. I feel that theory is based upon taxes and I have always been a believer you never want to let the tax tail wag the dog. As far as I am concerned, you want to do things that make good economic sense, not only for today, but also into the future. In addition, I do not believe that one strategy works for everyone. You always need to look at your individual situation and make decisions that work best for you, not necessarily what works for everyone else.

In reviewing your situation, one thing you need to keep in mind is that since you are in your late 60s, in just a few years you will have to begin taking minimum required distributions from your traditional IRA. The Roth IRA can continue to grow tax-free for as long as you choose, but you will be required to take minimum required distributions, from your traditional IRA. In many situations such as yours, it pays to begin to withdraw first from your traditional IRA, reducing your future minimum required distributions.

Although I do not ever want to let the tax tail wag the dog, it does not mean I do not want to take taxes into consideration. Taxes are important and we certainly do not want to pay more taxes than we have to. That being said, what I would recommend is taking a look at your tax situation and, in order to supplement your income needs, withdraw first from your traditional IRA, but only enough to keep you in the same tax bracket. Then, for additional monies you may need, I would then take it from the personal account. I would let the Roth IRA continue to reinvest and grow tax-free into the future.

Once you begin taking your minimum required distributions, I would follow the same strategy. If after taking your minimum required distributions you need additional money, I would first look to withdraw from the traditional IRA, but only withdraw enough to keep you in the same tax bracket. Remember, minimum required distributions are only the minimum; there is nothing to say that you cannot take more.

I recognize that the general belief is you should let your IRA grow for as long as you can before you tap into it. This is based on the belief that since traditional IRAs grow tax-deferred, it’s always better to defer your taxes for as long as possible . That sounds like a good strategy, but what people don’t realize is that sometimes, when you defer your taxes, you are deferring yourself into a higher bracket; the deferral did not save you taxes, it cost you. Therefore, do not be caught up in the mistaken belief that tax deferral is always good, because it is not. In many situations, you would be much further ahead by paying the taxes today versus in the future.

Good luck!

Rick Bloom is a fee-only financial adviser. His website is www.bloomassetmanagement.com. If you would like him to respond to questions, email rick@bloomassetmanagement.com.

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